Action bias - Why it’s important to master the art of patience
It’s long been known that bad investment decisions can be caused by our susceptibility to emotions and cognitive errors. But to really understand these behavioural risks and how to avoid them, it helps to see how they work in different ways. The analyst James Montier once used some research about goalkeepers to do just this, and this is how he put it...
Imagine you’re a goalkeeper facing a penalty kick. As the striker hits the ball, is it best to dive left, right or stay in the centre? In research, goalkeepers have been found to dive one way or the other a massive 94 percent of the time. Yet the optimal strategy is to remain unmoved in the middle of the goal.
So why do goalkeepers tend to dive one way or the other? The answer is that faced with a likelihood of conceding a goal, their instinct is to be seen to be doing something to stop it. If the ball flies into the top left or right corner, they’d surely be berated for remaining unmoved. But if they dive the wrong way… well, at least their intentions were good.
This is called action bias, and it manifests itself in different ways. It could be changing queues at a supermarket checkout, taking an alternative route on a congested road or trading shares absent-mindedly. This instinctive desire to take action gives us a sense of control, yet the outcome is likely to be the same or very possibly worse.
Why action bias is hazardous
In practice, the immediate result of a bad dose of action bias is over-trading. The desire for a sense of control - whether it’s caused by boredom, overconfidence, chasing new ideas or even blind panic - leads to unnecessary trading. It’s the costs connected with all that trading that can damage returns.
Research back in 2000 by the behavioural finance professors Brad Barber and Terrance Odean, found that individual investors pay a “tremendous performance penalty” for active trading. Their analysis of accounts at a large American discount stock broker between 1991 to 1996, found that those trading the most earned an 11.4 percent annual return, while the market returned 17.9 percent.
They found that a massive part of the problem, was that the average portfolio saw a 75 percent annual turnover. And it was the spreads and commission fees on those trades that proved to be devastating.
Now transaction costs have undoubtedly come down since the mid-nineties. But it’s still the case that spreads and commissions are a headwind on returns, so they need to be minimised.
How to manage the temptation to act
The antidote to action bias is patience, a discipline that demands a huge amount of self-control. In Montier’s words, “patience is a weapon you can use to stop yourself becoming an ADHD investor.” In some respects patience is really the key ingredient in long-term buy-and-hold investing, of which Warren Buffett is probably one of the best known advocates. In his view: “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”
But the importance of emotional control and being patient isn’t just the preserve of long-term investors; it applies to any strategy. Robbie Burns, the Naked Trader, who certainly in the past was relatively active in the market, once said to me: “If in doubt do nowt. If you find yourself over-screening and pushing every button in sight then there is probably something going wrong. You’re panicking, you’re fearful or you’re greedy.”
That sentiment is very much matched by Mark Minervini, in his new book Think and Trade Like a Champion. In that he urges investors and traders to develop a kind of “sit-out power” and uses a great analogy of a cheetah waiting for a wounded antelope. The cheetah might be starving but it’s smart enough to know not to waste its energy on a low-probability kill.
What Minervini says applies equally to any kind of investor, in that once you circumvent your own rules - by taking actions for poor reasons - then you have no strategy. As he says: “To make money consistently, you must stay disciplined. Follow your strategy and the trading rules that keep you from entering premature, ill-timed and risky trades for no other reason that you just want to be in the market.”
There are arguably hundreds of behavioural biases that can have a negative influence on investors and affect their returns. But the instinctive nature of action bias means it permeates all areas investing. Across the spectrum - from buy-and-hold to regular trading - action bias is a risk everywhere. As soon as an investor has veered away from a preset strategy, then emotions have taken control. At that point, there is arguably a much higher chance that investment returns can be wrecked by poor, instinctive decision making and over-trading. So regardless of the strategy, patience is crucial.
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Action bias in practice. I was faced with a classic dilemma today on a stock I am most grateful to Ed for highlighting in his first set of "naps" for 2015: Cranswick (LON:CWK) - I first bought the shares in January 2015 @ £13.90. Following yet more strong results yesterday they have now climbed to over £32.60.
Historically, I would have been tempted to sell (and I have already trimmed my holding to satisfy my asset allocation criteria), with the forward P/E exceeding 20 and Cranswick's low yield being a poor fit for my current portfolio strategy. But, I am mindful of Ed's original article where he pointed out Cranswick's long track record of delivering for shareholders.
A couple of other things I note: brokers have upgraded their EPS forecasts for the current and future financial years, reflecting the strong interims, so the forward P/E is not quite as high as current Stockopedia figures suggest (if the new broker forecasts are met or exceeded). Also I rang the firm to find out a bit more about their planned £54m investment in poultry in Suffolk. I established that this will be purely a processing plant, largely fed from Cranswick's own flocks. The poultry category is now doing very well for the company, as the results show, and this investment should enable a significant increase in production volumes and hence revenues, from FY2020 onwards. Though I didn't ask, I would expect a new facility of this type to incorporate a high degree of automation, increasing productivity and mitigating possible increases in staff costs in a post-Brexit world.
So, plenty of evidence that management is doing the right things and will be able to continue to deliver strong growth for shareholders.
Therefore I have had to resist my "action bias" and will sit on my hands.
In my eyes, Cranswick is vulnerable to a general UK market derating, but I am prepared to accept that risk and were it to happen, may consider using some of my cash buffer to top up my investment in what appears to be an excellent "bottom drawer" business.
Cheers,
Mark
I agree with all Herbie47 says. The investment book that I respect the most - Stan Weinstein's secrets for profiting in bull and bear markets splits traders into 2 categories Investors (buy and hold) and Traders (try to take advantages of the rises and falls by use of channels, volumes and moving averages).
Now Weinstein wrote that in 1988 (my copy is from then, dunno if it wqs ever updated) but not much has changed - except for the explosion in information - and the great blessing of Stockopedia
Much of Minervini is in Weinstein (not accusing Minervini of plagiarism, I rate his Trade Like a Stock Market Wizard very highly too - great minds think alike maybe), but to my mind Weinstein says things in a more detailed way. Both of them have lots about technical analysis
...anyway, that's by the bye. If you buy and hold, make as sure as you can you buy the right shares - and Stockopedia is invaluable there - if you want to ride the tides, make sure you can surf: and that (technical analysis) is tricky, but can be, in my experience, rewarding
Really good article, thanks. I also find that I buy in "clusters" as well, so I can do nothing for a few months but then buy or sell 4 or 5 holdings in a short space of time - to coin a popular phrase, "once you pop, you cant stop". I was wondering if this is a common phenomenon affecting those purporting to be medium to long term holders. Please could we have some more articles on psychological biases that negatively impact on investors, I find the psychology of investing fascinating & can recommend "Your Money & Your Brain", by Jason Zweig as a decent read.
It's an interesting fact that the 2017 NAPS is up about 39% ytd with a maximum drawdown so far of less than -5%. It has done this even though two of its constituent stocks have fallen by more than 50% each. You can see the wild excursions of each stock in grey and the surprisingly smooth mean value in magenta in the plot below.
Perhaps you could have monitored the stocks daily and tried to choose the best time to exit non-performing stocks. But you would then have to find a replacement stock which was expected to perform better going forwards, and maybe you would have sold other stocks too soon too.
Or, alternatively, having chosen twenty "good" stocks in January which were well diversified across sectors, you could walk away and allow the statistics to smooth things out. This year's NAPS is perhaps exceptional in its low volatility and small drawdowns, but it provides an excellent worked example of the kind of performance you can get if you ignore short term volatility in the market and in individual stocks.
"It's an interesting fact that the 2017 NAPS is up about 39% ytd". That's a remarkably good performance, as the FTSE All Share index is up by just 5% in this year to date! It's certainly significantly better than what I've achieved in my own portfolios, and I thought I'd had a good year so far. Perhaps I should give up trying to pick my own stocks and just mimic the NAPs portfolios each year.
Very thought provoking . I wonder what the Stockopedia NAPs have done each year since it was started . Is this data readily available ?
I agree with A Biggins above who stressed the importance of buying the right shares and the usefulness of Stockopedia in this respect.
Thanks
There's a meditation saying, 'don't just do something, sit there.' I deffo need more patience.
Going back to the penalty analogy, there is a rationale to diving one way or the other rather than standing still. When a striker puts the ball on the spot they know If they shoot, or audaciously chip, straight down the middle and the goalie stands still and catches it or beats the ball away he is going to be mocked for the rest of his career by opposing fans, his own team mates on the training ground, people in the street, his children, his grand-children when they see the replay, by Gary Lineker and Alan Shearer back in the studio. May as well stick to booting it in the corner, just to be on the safe side. Doesn't look so bad if it's saved, (but a bit rubbish if you miss the target altogether). Goalies suspect this looking like a berk action-bias is similarly at work.
So:
Slightly more shots were placed to the goal keeper’s right side compared to the center or left. Of these three directions, kickers were most successful when shooting at the center of the goal. Shots aimed at the center of the goal were successful 87% of the time compared to an 83% success rate for shots placed at the outer thirds of the goal.
And:
Goal keeping behavior explains part of the goal scoring successes. In attempting to stop the penalty kick, goal keepers jump to the right or left 94% of the time. In doing this, they guess correctly only about 40% of the time (i.e. jump left, shot placed left). However, even when they guess correctly, they only stop 25-30% of the shots. The most intriguing part of the Dr. Bar-Eli’s analyses is that when goal keepers remain in the center of the goal and the shot is placed in the center, they make the save 60% of the time. Given that about 30% of penalty kicks are placed in the center third of the goal, remaining stationary in the center of the goal increases the keepers chances of stopping the shot from about 13% to more than 33%.
All from http://www.scienceofsocceronli...
Of course, if a goalkeeper stands still for a few penalty kicks penalty takers will get wise and start to hit the ball to the sides, it's hard to imagine the equivalent of markets suddenly starting to deliberately target my portfolio (although it feels like it sometimes).
Action bias is often also seen in paired trades - people often sell one stock to buy another. The research suggests that the shares sold tend to outperform the shares bought, When I looked at my own behaviour I found the same pattern so I try these days to separate sales and purchases. Basically, all share trades come trailing clouds of uncertainty atop a volcano of risk but we can at least try not to fan the flames.
timarr
- 2015: 43%
- 2016: 5%
- 2017: 41%
2016 was notably weak, but the other 2 years hugely successful. The portfolio is up over 112% to date in less than 3 years.
I'll be blogging about this soon - and probably doing some webinars in January. Stay tuned.
Action bias requires decisions to be made on subjective basis, if following a mechanical investment method there is no real room for it. Whether you are bored, content, anxious or calm, you still only sell or buy according to certain criteria.
Personally I struggle to blindly following criteria, though. If a screen throws up a company with something dubious in their finances or elsewhere, I will reject them. I also try to follow a rule that someone with a long track-record of success told me; If their business model does not make sense to me it a suitable company for me.
This resulted in an unusual situation recently, where I sold a company as per criteria but was unable to find a suitable replacement to fit my diversification goals. In the end, I decided to just sit on the cash for a while until I found a suitable replacement rather than buy something "just to spend the money".
If trading AIM stocks, although one might save on stamp duty - the bid offer spreads are so wide that trading too actively is really punishing.
Looking forward to that Ed.
I know you’ve done pretty exhaustive testing in the past to see if you were just lucky with the NAPS portfolio selected (to see if by chance it happened to be an outlier in the universe of possible NAPS portfolios) and found it not to have been a substantial outlier. So, hopefully you’ll be able to do something like that again as it would be really interesting to see how much of the performance was down to an element of luck selecting IQE and not selecting a poor performer for example.
Another suggestion would be to get every person in the office to pick a NAPS portfolio independently of each other for next year and see how they do to try and minimise the possibility that you are not somehow sub-consciously filtering to choose the better companies (within the NAPS rules) based on your greater level of experience and expertise than the average. Can the Stockopedia office cleaner’s NAPS portfolio do equally well?
In response to your query about buying and selling in clusters, I don't know how common this is but I read a research paper a year or so ago - sorry I can't remember where - which suggested that investors who bought and sold in clusters achieved better results on average than those who bought and sold single stocks.
The suggestion was that buying and selling in clusters reduced the risk of emotional attachment to individual stocks or decisions and therefore reduced cognitive bias and allowed more objective decision making. It is possible I suppose that those who buy and sell in clusters are more likely to be operating a purely mechanical strategy in the first place, but the analysis made sense to me.
Ed,
I don’t suppose I’m by any means the first to suggest this, but have you considered partnering with an ETF provider to offer a Stockopedia ETF with the stocks selected based on similar criteria to the NAPs?
IBD do something along these lines with the FFTY fund in the US based on their IBD 50 stocks.
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I am sorry for the wounded antelope. I would not wish to destroy nor wound others in the pursuit of profit.